Correction: A previous version of this article incorrectly described the European Central Bank’s policy on accepting Italian government bonds as collateral. Many private lenders, but not the ECB, have refused to take Italian bonds as collateral, thus driving up funding costs for Italian banks and weakening their financial positions. This version has been corrected.

A person walks out of the headquarters of Monte dei Paschi bank in Siena, Italy, the oldest bank in the world. The 540-year-old bank is struggling because of poor investment decisions and the financial problems of the Italian government. (Michael Birnbaum/The Washington Post)

SIENA, Italy — Tucked away in this Tuscan city, the oldest bank in the world has survived the Borgias, pestilence and too many wars to count. Now, a mundane foe has proved far more dangerous: Italian government debt.

The 540-year-old Monte dei Paschi Bank, Italy’s third-largest, is on the ropes as it struggles to deal with holdings of Italian bonds, once considered a prudent place to tuck cash.

The euro crisis upset that calculation. Across Europe, banks are confronting the same problem as seemingly safe bets that governments would repay their debts turned out to have been major gambles.

At the heart of the crisis, the tangled relationship between governments and the financial sector amplifies the financial problems on both sides. And in Siena, bountiful profits that once poured from Monte dei Paschi’s treasure-filled Gothic palazzo have dried up. Last week, the bank announced that it had lost $2 billion in the first half of 2012.

Analysts and the bank’s current management say a long-prudent institution — based in the same building since 1472 — got caught up in the froth of the cheap-credit years before the crash and then made poor decisions about how to recover.

Siena, Italy’s main plaza. The city is home to Monte dei Paschi bank, the oldest in the world. (Michael Birnbaum/The Washington Post)

“It was really an orthodox and cautious bank,” said Angelo Ricca­boni, rector of the University of Siena, which last year lost funding that would have come from bank profits. In Siena, he said, “people are either employees of the bank, or former employees of the bank, or would like to be employees of the bank. The city and the bank are so intertwined.”

Monte dei Paschi was lending money when Christopher Columbus was still dreaming of the shortest route from home to the shipyard, not India. But the bank’s financial situation deteriorated after it purchased a rival in 2007 in an ill-fated attempt to expand its reach across all of Italy. That decision resulted in massive debts from which the bank is still struggling to recover. The bank now appears to be the worst-off in Italy, with major capital shortfalls and a plunging share price.

The 55,000 residents of Siena are looking at the bank they call “Daddy Monte” with a newfound sense of vulnerability. This year, Sienese owners were forced to give up their majority stake in the bank, and many residents fear that the bank that has helped define the city’s identity for more than five centuries will soon slip away from them.

Profits from the bank financed the Palio, a traditional horse race in the town’s austere center square. They paid for renovations to the city’s severe Gothic buildings. They underwrote biotech programs intended to turn the Tuscan plain into a research hub. Nearly all that money — $150 million a year, on average, from 1996 to 2010 — has evaporated in the past two years.

“Nobody thought the banks would be in crisis, and then nobody thought Monte Paschi would be in crisis,” said Franco Ceccuzzi, the former mayor of Siena, who was forced to resign this year after losing support over the handling of the city’s interest in the bank’s management.

The bank’s troubles have caused soul-searching among city residents, some of whom wonder whether the easy money blinded them to problems as the crisis developed.

“When you have money, when it’s floating around, nobody is as careful,” said Walter Bagni, 35, who works at a major vaccine manufacturer that has a research center in Siena.

‘Not a prudent decision’

At the bank — which keeps watch over its assets so carefully that a glass coffee table in a lavishly furnished waiting room bears a tracking bar code — new managers say they have a plan to restore the bank to profitability by 2015.

“The problem of Monte Paschi was the fact that over the last two years, they invested a lot, in my opinion too much, in the government portfolio,” Fabrizio Viola, chief executive of Monte dei Paschi, said in an interview. “It was not a prudent decision.”

But he said government bonds are a distinct type of investment. “It would be a completely different thing if the bank issued loans to real estate and it caused a capital shortfall,” he said, alluding to the property bubble that was a major factor in the financial crises in Spain, Ireland and the United States.

Throughout the euro crisis, governments and banks have had difficulty separating their fortunes. Ireland’s government, which had been careful with its spending before the crisis, had to resort to a bailout after it took on the bad debts of its sizable banking sector.

The Spanish and Italian governments, meanwhile, have found themselves at risk of needing bailouts as investors demand significantly higher rates of interest to lend to them. Higher rates have, in turn, added to the stress on Monte dei Paschi’s finances, because it can sell only its holdings of less-safe Italian bonds at a loss.

“If you’re concerned about the Italian government, you’re going to be concerned about the Italian banks, too,” said Ben May, an analyst at Capital Economics, a London-based research firm. “If you were going to see a fairly big government default, you’d be wiping out a big chunk of Italian banking capital.”

A range of vulnerabilities

Attempts to help banks and to unfreeze European credit markets have had mixed results, suggesting just how intractable the problem is. The European Central Bank initiated an emergency program at the end of last year to give short-term credit on generous terms to banks. That led to the banks’ buying even more government bonds, further binding them to their governments.

Many private lenders have deemed long-term Italian government bonds too risky and refuse to take them as collateral. As a result, banks with large holdings of the bonds need to find other assets or raise money to back basic operations. Monte dei Paschi appears poised to give the Italian government an ownership stake in exchange for much-needed cash to bolster its capital.

Analysts say some of Monte dei Paschi’s troubles are unique. Unlike with other banks, a Sienese foundation owned the majority stake, and the foundation did everything it could to preserve local control. When the going got rough, the foundation refused to dilute its stake by issuing new shares to raise money, a stand that weakened the bank’s finances.

The bank was also being managed, some analysts say, by a parochial team whose members’ chief qualification was that they were from Siena and who made decisions based on local political interests rather than what was economically best for the bank.

“This is a problem with the governance of Italian banks,” said Tito Boeri, an economist at Bocconi University in Milan. “But with Monte Paschi, it’s really an extreme case.”

“The foundation was doing whatever they could to maintain this stake in the bank, and it’s obvious they completely destroyed their asset,” he said.

Despite all the distress, some Siena residents think the bank’s troubles will have a positive effect on the city’s life.

“Before, there was too much money given out, forcing a laziness,” said Fabio Pacciani, a dentist who heads the confederation of organizations that run the annual horse races. “This will force more collaboration, more volunteerism.”

Pacciani went on: “All this well-being was being brought from the bank. It brought a flattening of civic sense because there was so much money.”

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